Growing pension deficits cause fallout for U.K. corporations

The defined benefit plan's role in a corporation is once again becoming increasingly important for U.K. companies, industry experts say.

Impacts range from exacerbating share price falls such as at Tesco PLC, whose stock price dropped late last month on speculation of an increased pension fund deficit, to stalling mergers and acquisitions and sometimes even contributing to the end of M&A talks.

And in some cases, a large pension fund deficit can be a benefit to a corporation if it makes it an unattractive takeover target, as was the case several years ago for BT Group PLC.

“The fact that pension plans have become such a large deal is an inevitable consequence of 50 years of defined benefit liability accrual, and at the end of that period we have (in some cases) substantial sums of money which will cast a shadow over the corporation that is responsible for it,” said Bob Collie, Seattle-based chief research strategist, Americas institutional, at Russell Investments.

Global supermarket giant Tesco, Cheshunt, England, on April 20 saw its share price fall 0.72% to 235 pence, with fluctuations throughout the day, amid speculation that the deficit on its £8.4 billion ($12.6 billion) pension fund had swelled to £5 billion. The deficit as of Feb. 28 was revealed as £3.9 billion two days later, along with a record annual corporate loss of £6.4 billion. On April 22, the share price fell 5.4% to 223 pence.

In an analyst presentation April 22, David Lewis, Tesco CEO, said the company had reached an agreement with pension fund trustees under which Tesco will make cash contributions of £270 million a year to the pension fund, to be reviewed every three years. The corporation is also in the midst of a consultation into the closure of the pension fund.

“Defined benefit obligations do impact on corporate life, but there is a balance to be struck,” said Tony Hobman, London-based chairman of the advisory board at pensions advisory business Lincoln Pensions Ltd., and former CEO of the U.K.'s The Pensions Regulator. “There may be competition for cash in a (corporation) — does it go into supporting a (pension) scheme, or should it be used for other areas of the business, like research and development? Under the new code (from The Pensions Regulator) and the regulator's statutory objective, scheme funding needs to be seen in the context of employers' sustainable growing plans.”

Pension funds are also a significant focus for equity analysts when valuing a firm. Peter Elwin, deputy head of European equity research at J.P. Morgan Chase & Co. in London, said: “The significance of a pension scheme to a company is best assessed by comparing the underlying liability with the company's market cap. If the pension liability is the same size as the market cap or more, then that's a potential concern.”

Mr. Elwin said he looks at the liability rather than the deficit, “because that is very volatile. You can have a plan with a surplus one day, and then none.” There is also no credit awarded to a corporation with a pension fund surplus.

Clive Black, head of research at Shore Capital Group Ltd. in Liverpool, England, added that pension responsibilities are one of the factors that “are materially considered” when making a valuation. “There is plenty of evidence where the pensions tail wags the dog. But over the past five to 10 years, there has been significant progress made by British corporations in managing their pensions responsibilities.”

It is not just the share price that comes under pressure from DB deficits; merger and acquisition activity has also been hit.

“There is now much more enfranchisement of pension schemes in the M&A process with a greater understanding that this stakeholder group needs to be appropriately treated in a transaction,” said Darren Redmayne, London-based managing director at Lincoln Pensions. “As such, pension schemes can move from being at the periphery to being front and center in an M&A transaction.”

One corporate adviser said he has seen a potential acquisition by a private equity firm fall through because the target's pension fund had a deficit. “The private equity firm was extremely conservative on the funding that it would require to turn around that deficit, and it prevented them from buying the business,” said Vincent Bounie, a London-based managing director at corporate adviser Fenchurch Advisory Partners LLP.

Another current deal in financial services, Mr. Bounie said, is close to being announced, but a question hangs over a pension fund deficit. “It is holding it back. The buyer wants to knock down the purchase price because of a deficit — that is a big wake-up call for the seller. Pension deficits are a big issue in transactions. It is because of the sheer size of some of those schemes compared to the size of a corporate's equity.”

Pension liabilities — regardless of whether they amount to a surplus or a deficit for a corporation — can be a deciding factor. With the transfer of pension fund assets and liabilities from one company to another, “you still have the potential for future deficits. It is almost certain that the (buying) entity would not want to take on existing pension liabilities, even if there is no deficit attached, just because of the instability that it introduces to the situation,” Russell's Mr. Collie said.

Specialist DB insurer Pension Insurance Corp. PLC is regularly approached by companies in or contemplating a transaction about liabilities on a balance sheet. “The seller doesn't want to keep them, the buyer doesn't want to buy them, and if either party keeps (the pension fund or the liabilities) the trustees don't want to be disadvantaged,” said David Collinson, head of strategic development at PIC, London. “Sometimes it leads to an insurance transaction; sometimes the deal falls away because there is too much of an uncertainty. There is a lot of pressure on getting it right, but sometimes the cost of insurance exceeds the value of the transaction.”

But a deficit can also help a corporation in some cases.

“It is interesting and true that while pension schemes can be large, problematic risks for companies to deal with, on occasion, particularly if a company wants to remain independent and thwart takeover approaches, you can have situations where the pension (fund) itself is of such a size and risk that it makes the business quite unattractive to any potential suitor,” Lincoln's Mr. Redmayne said.

He was referring to comments by BT Group PLC Chief Financial Officer Tony Chanmugam last week that the telecommunication giant's pension fund deficit during the 2008 financial crisis made it too unattractive to be a takeover target.

The London-based pension fund has a £7 billion deficit, and agreed with the corporation in January to a £2 billion-a-year contribution program.

Said Mr. Redmayne: “When there are financial difficulties or a stress period, sometimes a company can be vulnerable to takeover approaches. Quite often they just want time to deal with their problems, grow and recover: A pensions deficit can ironically dissuade potential acquirers and give companies that breathing space to do the turnaround, or make the strategic changes that they need to make.” n